The Nature of

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Chapter 3

• The Nature of
• Health Insurance Markets

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A. Why Are There Markets for Insurance?

• 1. Why is there a demand for insurance?
• Consumers are willing to purchase insurance
  because they are risk
• averse.
• What does being risk averse mean?
• The disutility of an expected loss associated
  with an uncertain (and
• probably unlikely) adverse outcome is greater
  than the disutility of
• a certain small loss (the cost of the insurance)
  entails. Risk aversion
• is an equal but certain small lost (the cost of
  the insurance).

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A. Why Are There Markets for Insurance?

• EU expected utility
• The weighted average of the utilities associated
  with possible outcomes, where the weight is the
  probability that a given outcome will occur.
• Risk aversion can be illustrated
  diagrammatically In the following
• figure, EU is the expected utility of an
  uncertain outcome. U is the
• utility associated with a certain outcome. Here,
  a person with
• wealth 15,000 pays 200 for insurance. Her
  certain (net) income
• will be 14,800. Since this provides greater
  utility than a 10
• chance of incurring a 1000 medical bill, which
  leaves her with an
• expected income of 14,900, she is risk averse.

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A. Why Are There Markets for Insurance?

• Figure 3.1 Risk Aversion Illustrated

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A. Why Are There Markets for Insurance?

• 2. Why is there a supply of insurance?
• Insurance companies Insurance companies estimate
  what their
• average payouts will be. If they can charge more
  than the average
• payout to cover costs, they can make profits.
• Consumers Risk averse consumers are willing to
  pay more than
• the expected value of their losses for insurance.
  The amount the
• consumer is willing to pay over the actuarial
  fair value of the policy
• is called the load or loading fee. This is the
  price of transferring risk
• to the insurance company.

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A. Why Are There Markets for Insurance?

• The load (L) is often expressed as a ratio
  between the price of
• insurance, the premium, and the expected payout
  (E)
• L 100 x (Premium / E 1)
• In the equation (above) the marginal utility of
  wealth is decreasing
• as wealth increases. When that is true, the
  slope of the EU curve
• decreases as wealth increases.
• In that situation, an individual will be willing
  to take an unfair bet,
• e.g. pay more for insurance than the expected
  value of the loss
• against which he is insuring himself.

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B. Insurance and Consumer Behavior

• Moral Hazard
• If being insured affects behavior in such a way
  that the expected
• payout from the insurance company is increased,
  this is called
• moral hazard.
• Health insurance is unlike most other forms of
  insurance
• Reduces the cost of the expenditure (medical
  care) associated with adverse outcome, e.g.
  illness.
• Main form of moral hazard associated with having
  health insurance is increased use of medical care
  by an individual or family.
• With other types of insurance, moral hazard is
  usually associated with behavior that affects the
  likelihood of the adverse outcome.

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B. Insurance and Consumer Behavior

• If the demand for medical care is the usual
  downward sloping
• function, and if health insurance reduces the
  price of medical care,
• being insured would tend to lead to the use of
  more medical care,
• everything else being held constant.
• If an insurance policy is structured so that the
  insured pays only the
• premium, after which medical care is free, demand
  is represented
• by D2D in Fig. 3.2.
• If the insurance company pays half the bill and
  the insured pays the
• other half (e.g. has a 50 co-payment), then the
  demand curve
• shifts to D1D. Without insurance the demand is
  shown by D0D.

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B. Insurance and Consumer Behavior

• Figure 3.2 Effects of Insurance on Consumption
  of Medical Care

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B. Insurance and Consumer Behavior

• Offsetting Moral Hazard
• Insurance companies structure insurance policies
  so as to offset
• moral hazard. The usual ways are
• Deductibles
• Co-payments
• Life-time limits on payouts
• Reimbursing in accordance with usual or
  customary fees

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B. Insurance and Consumer Behavior

• Adverse Selection
• Adverse selection exists when people who are more
  likely to buy
• insurance or policies with more extensive
  coverage are also more
• likely to use more insured medical services.
• Adverse selection in an insurance pool will
• Drive up the price of insurance premiums, causing
  those who expect to purchase fewer insured
  services (the younger and healthier) to drop out
  of the pool.
• May lead to a Death Spiral - the pool of
  insured will become smaller and smaller, with
  only the high risk members of the pool remaining,
  in which case, the insurer may discontinue
  marketing the product, since the market has
  shrunk.

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B. Insurance and Consumer Behavior

• Offsetting Adverse Selection
• If insurance companies can distinguish
  individuals who are higher
• and lower risk and can set prices in accordance
  with this, adverse
• selection can be offset.
• One technique is to price using experience
  rating pricing
• premiums on the basis of past payouts.
• Another related technique is to demand medical
  records, and
• to price in accordance with apparent health
  status, in some
• cases providing insurance that excludes coverage
  of pre-existing
• conditions.

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C. Group Health Insurance

• In the United States, most private insurance is
  employment-based
• group health insurance. It has historically been
  very popular with
• workers and employers.
• (1) Group health insurance partially offsets the
  problem of adverse
• selection. Within groups there is community
  rating, e.g. no price
• discrimination based on medical histories or
  personal characteristics
• of individual members of the group.
• (2) All employment-based group health insurance
  receives favorable
• tax treatment employees are not taxed on the
  value of the
• insurance policy, and employers can deduct the
  cost of their
• contribution to employee insurance premiums as
  part of the cost of
• production.
• (3) Except for very small groups, or those known
  to be
• characterized by adverse selection, group health
  insurance
• premiums are much lower than are premiums on
  insurance
• purchased by individual families.

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C. Group Health Insurance

• There are some disadvantages to a system of
  employment-based
• health insurance.
• (1) It tends to tie people to their jobs (job
  lock) and therefore
• reduces labor mobility.
• (2) Small firms often cannot afford to provide
  workers with
• insurance, so the employment-based system, when
  not mandatory,
• leaves many workers without access to affordable
  insurance.
• (3) The unemployed face the double insecurity of
  loss of wages and
• loss of health insurance.
• (4) Employers are cutting back on their
  contribution to employee
• health insurance, with the result that many
  workers now do not have
• insurance because they drop out of the firms
  plan when they have
• to pay an increasingly large part of the premium.

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D. Community Effects of Health Insurance

• Over time, at least until the last decade, U.S.
  workers have opted
• for more comprehensive health insurance coverage,
  usually
• largely paid for up front by employers. The
  favorable tax
• treatment of employment-based group insurance has
  augmented
• this demand for health insurance. (In the 1950s,
  most people had,
• at most, insurance covering hospitalization).
• Some economists believe that this has led to
  negative aggregate
• welfare effects. (Martin Feldstein is an example
  of this point
• of view). They argue that too much insurance is
  inefficient and
• leads to consumption of medical care to the
  point where the
• marginal benefit, certainly the marginal social
  benefit, is less than
• the marginal social cost. The good effects of
  insurance coverage
• are partly offset by the increase in the price of
  health care that
• results from the increased demand of the
  community.

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D. Community Effects of Health Insurance

• Figure 3.3 Communitys Insurance Coverage and
  Demand for Health Care

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D. Community Effects of Health Insurance

• An alternative view of the welfare effects of
  group health insurance
• has emerged (John Nyman)
• (1) The negative welfare effects of excess
  health insurance are
• based on an analysis that focuses on the negative
  moral hazard
• effects resulting from lower prices of medical
  care for individuals.
• (2) If one considers the income transfer from
  healthy to sick
• individuals within an insurance pool, there are
  offsetting positive
• welfare effects when people are able to purchase
  more medical
• care as a result of the implicit income transfer.
  
• (3) Group health insurance has also increased
  access to insurance
• for people who otherwise would have found it too
  expensive to
• purchase in the individual market.